Under Pricing of Initial Public Offerings

Under Pricing of Initial Public OfferingsInvestopedia.com defines initial public introduceing as the first sale of downslope by a private community to the public. IPOs argon much skipd by downhearteder, younger companies seeking the pileus to expand, but lot also be d one and only(a) by large privately owned companies looking to become publicly traded.In an IPO, the issuer obtains the assistance of an underwriting unassailable, which helps it determine what type of warranter to issue (common or preferred), the best offering price and the time to bring it to market.1IPO INITIATION AND THE PHASES OF IPO TRANSFORMATIONAny IPO goes through the future(a) stages of trans makeupThe pre-IPO transformation phase crowd out be considered to be a restructuring phase where a beau monde starts the groundwork toward becoming a publicly-traded company. Furthermore, companies should re-examine their organizational processes and policies and make necessary changes to enhance the companys corporate governance and transpargonncy. Most importantly, the company needs to develop an effective growth and business strategy that brush aside post potential investors the company is profitable and behind become even more profitable. On average, this phase usually takes around two years to complete.The IPO exertion phase usually takes place right before the shares are sold and involves achieving goals that would enhance the optimal initial valuation of the loaded. The strike issue with this step is to increase investor confidence and credibility to ensure that the issue go forth be successful. The intent of these actions is to prove to potential investors that the company is willing to spend a little special(a) in order to generate the IPO handled promptly and correctly.The post-IPO transaction phase involves the execution of the promises and business strategies the company committed to in the preceding stages. The companies should not give to meet expectations, but rather, beat their expectations2The marketing process of going public is marked by what is called road show.road shows involving Issuers and key managers of the company to potential investors via presentations in major cities and face to face with the tar bring investors (Ritter, 1998).These presentations focus on business operations, products and services, and management.The visit aims to assess the expected essential for the shares of the company and serves as a key input in the final determination of the initial price of the sharesAt the end of the road shows, and just prior to the actual first day of avocation (usually days before opening day), needors and underwriters will determine the initial offering price.This is quite important because once the price is determined in that location is no screen background of increasing it even if there is high demand for it. This is how stocks become underpriced. By the close of the first trading day a huge difference can be seen betw een the actual price and listed price. The concept of under-pricing is dealt with more detail in the following section.THE CONCEPT OF UNDERPRICINGUnder-pricing is the difference between the initial offered price of the stock and the price at the closing curtain of the first day of trading (Ibbotson, 1975, Ibbotson, Sindelar and Ritter, 1988 Ritter, 1998). This undervaluation is not unusual for companies to commit.To illustrate, suppose the initial price of a firm issuing 1 million share is $100/share. This would result in a capital of $100 million for the company when all the shares are sold. Now suppose towards the closing of the day, the share is traded at $150. This would mean that the share was underpriced by 50%. This results in an available profit of $50 million for the initial investors. This phenomenon is seen universally across essential and developing countries. This trend of under-pricing can be seen as going against the concept of market efficiency and may cause distr ess to firms trying to collect capital for expansion. In this regard much research has been done and much literature has also been written.The theory of efficient markets suggests that the price of newly issued shares will quickly conform to all relevant available information in the market (Fama, 1970) reflect.However the constant undervaluation has raised questions about what happens when companies go public.The decision to go public is one of the largest in corporate finance.Even developed economies like the US, a number of large companies are not public. This shows that going public is not mandatory for a company but it is a choice. However there is a clear disparity between companies choosing to use the stock market and the companies that do not.A company basically goes public to either diversify their portfolios or to raise capital to invest in future projects. Some other reasons why a company expertness opt for going public include overcoming debt, change of controls and to enhance prospect.WHY ARE IPOs UNDERPRICED A LITERATURE REVIEWThere are direct and indirect which are borne by the company when an IPO is issued. The indirect cost is the cost associated with information provision to the stock market and the direct costs are the numerous costs which are associated with fees and charges such as the underwriting fees, legal fees and auditing fees etc. However the most important among these and probably which affects the stock price once it is issued is the dilution associated once the shares start to change hands in the public. Often IPOs are found to be underpriced due to this dilution costs. and the IPOs are often subject to the practice of hand mental synthesis. Book building refers to the process of generating, capturing, and recording investor demand for shares during an IPO (or other securities during their issuance process) in order to support efficient price discovery.3In the solvent of an issue going public, the issuer always fixes a pric e great deal and allows the investor to quote a price within this price band. The upper limit of this price band is the maximum possible price to be paid for the IPO and hence there is a chance that the issue becomes underpriced in case there is unreasonable demand for the stock. In this the valuation of the stock often reaches an estimate before the stock transacts in the market. As such there is a chance that the stocks get oversubscribed. A peculiar trend can be seen in case of IPOs. The replicas are quite high in the initial period. But over a short period of time this return is normalized or completely minimized and the stock starts to trade at a mensurate close to its actual issue price. Therefore it may be wrong to assume that the stock is actually underpriced at the time of issue. Several factors can affect its high return which can include a bullish market also.Rock (1986) and Baron (1982) explained this under-pricing through their models. Baron assumed that investment bankers /underwriters possess more information on the demand of the security than the issuer. The issuer has to compensate the underwriter for this superior information set. Rock assumed that there are two groups of investors in the IPO market which are reason as the informed investor and the uninformed investors. Systematic under-pricing is needed so that the uninformed buyers can earn a normal expected returnThe price formation process for IPOs may be susceptible to the existence of significant conditional price trends in the short-run aftermarket for several reasonsFirst the market takes time to go down to the amount of analysis done on the announced issues and this time can extend over several months. There is a great deal of suspense around the IPOs because of the scarcity of public information available at the time of initial offering. indeed their true nurture seems highly uncertain to the public. The initial return of the stock is actually the first reaction of the peop le and goes on to show how the people assess the stock against the initial offering.Second, the first market price may fail to reflect fully all available information because of the potentially fragmented market for IPOs. The issue sizing of IPOs is typically small and the underwriters, often liner excess demand, ration new issues to their regular clients, who constitute a small subset of potential investors. Initial trading in the aftermarket serves to disseminate information about the order of IPOs to other investors. While initial upward price movement of underpriced IPOs spreads favorable information, the available supply of shares is restricted because underwriters typically discourage initial subscribers from selling their allotments in the aftermarket. Investors who were unable to obtain their full subscriptions at the offering may seek to buy shares in the aftermarket, resulting in a sequence of daily positive returns. In the case of an overpriced issue, the first market p rice fails to reflect the available information because of price stabilization by the underwriting syndicate.The under-pricing can be explained with the help of umpteen hypotheses. These are discussed belowThe Risk-Averse-Underwriter guessing In order to mitigate the risks and costs of underwriting the underwriters usually knowingly undervalue the stocks. However the investment bankers readily do their preparation and they have a fair idea of the actual value of the stock. Therefore this hypothesis only seems meaningful when there is a scope of book building and not when there is a case of fixed price offerings. Since both book building issues and seasoned equity offerings were historically underpriced, one cannot say that the main motive of under-pricing were the investment bankers desire to averse risk.The Monopsony-Power Hypothesis (Ritter, 1984) The investment banker enjoys monopsony power while analyzing common stocks of small firms. They then ration these to the most influ ential customers who have maintained good relations in the past. Further reasoning by different analyst suggested that this under pricing can also be targeted at earning excess income in the form of commission and fees. (Ritter, 1984) suggested that the gross under pricing might be result of the monopsony power of the investment bankers in underwriting common stocks of small speculative firms. According to Ritter, the investment bankers intentionally under price the securities and ration them to their large customers who regularly buy a variety of investment services from them.The Speculative-Bubble hypothesis This hypothesis says that one of the reasons for stock price to boom is due to those investors who could not grab a share during the IPO (because of oversubscribing) and those who speculate that the prices of these stocks will rise in the future. This was typical during the IT boom period.The point to wonder is what determines the true value of the stock. The true valuation an d the quality of the IPO can be analyzed by the followingRetained EquitySince firms can determine how much equity they will give out at the time of initial public offering. Since this figure can be obtained in advance therefore it serves as the most relevant and the most researched. Since the pre-IPO ownership of firm is determined and very unlikely to change, this becomes an extremely gruelling signal to imitate. It must be noted that any change in such information prior to the IPO can dampen the enthusiasm of the investors and might have significant impact on the value of the stock.Underwriter prestigeThe market value can be significantly changed due to the prestige tie with the underwriter. Those investment bankers who have a good reputation in the market will signal less uncertainty about the performance and offer value of the IPO. The valuations done by these investment bankers will be considered with less speculationBut even in the face of a prestigious investment banker doi ng the valuation, there is significant chance of under-pricing. These underwriters play with two key constituents in the IPO process. The underwriters representing the firm forms the first and the client base for whom the securities are marketed. The first constituent is the firm whose securities the underwriters represent. The second is the client base to whom the underwriters market the IPO securities.Auditor ReputationThe price of the IPO can also be influenced by the attender reputation. The auditors who are deemed as high quality will be judged with very less speculation and the investors will fairly accept the value of IPO set forth. If the auditor fails to reveal potential negative firm information, then the reputation of these high quality auditors may suffer. In some cases shareholders can also file a lawsuit.Number of Risk FactorsThe prospectus revealed by the issuer also details the risk factors pertaining to the company. The purpose for this is to let the investors asse ss the fair value of the IPO and the possible opportunity that might exist in investing in this IPO. Firms with more risk factors can be associated with higher(prenominal) uncertainty. Firms with greater numbers of risk factors are associated with higher uncertainty.Firm SizeLarger firm size often has greater resources and more opportunity to survive in extreme situations. Thus the firm size also motivates the price of the IPO. Several studies found that there is a negative correlation between underpricing and firm size. This is consistent with the relation between large firm size and more stability. Thus potential investors trust the IPO price to be close to its fair value when large firms are at stake. Moreover the larger firms also are associated with more prestigious underwriters.Firm AgeThe more the age of the firm will act as a protection from the risk and this is used in valuing the price of the IPO. This is because the younger firms have less number of published financial d ata and hence the valuations done for these firms are often subject to uncertainty. Moreover these firms are also not analyzed by financial analyst. Firm age and performance are often related.Offer costOne of the responsibilities of the lead investment bank is to assess the pre market demand for its clients prospective IPO in an effort to set a reasonable price. Thus this initial price might also instigate some amount of under-pricing. Also it has to be known that a very modest price will signal less demand and less value or maybe both. The initial price of an IPO offering may also have value as an indicator of underpricing. In the early stages of an IPO, the lead investment bank is responsible for assessing the premarket demand for its clients prospective IPO in an effort to set the offer price. Presumably, a very modest offer price will signal little demand, little value, or both